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To hear Robert Persons talk about some of his favorite holdings, you could easily mistake him for a classic bottoms-up stockpicker. There's
GapGPS 0.46371435195919314%Gap Inc.U.S.: NYSEUSD43.33
0.20.46371435195919314%
/Date(1427835763412-0500)/
Volume (Delayed 15m)
:
2707474AFTER HOURSUSD43.0429
-0.287099999999995-0.6625894299561504%
Volume (Delayed 15m)
:
18268
P/E Ratio
15.257042253521126Market Cap
18061593508.8191
Dividend Yield
2.1232402492499425% Rev. per Employee
116560More quote details and news »GPSinYour ValueYour ChangeShort position
(ticker: GPS), which he thinks is fashionable again. "They've improved their merchandising, and same-store sales have been very positive," he says. It's a similar story with
Delphi Automotive DLPH 0.6691074359298068%Delphi Automotive PLCU.S.: NYSEUSD79.74
0.530.6691074359298068%
/Date(1427836103780-0500)/
Volume (Delayed 15m)
:
2042247AFTER HOURSUSD79.7937
0.05370000000000630.0673438675696012%
Volume (Delayed 15m)
:
68318
P/E Ratio
17.72Market Cap
23058268112.0883
Dividend Yield
1.254075746175069% Rev. per Employee
134039More quote details and news »DLPHinYour ValueYour ChangeShort position
(DLPH), which came out of bankruptcy in 2009 and has been on a roll. "Over the past year, the stock has gone from $26 a share to $50 a share," he says.

Yet, as the co-manager of the $2.9 billion
MFS Bond
fund (MFBFX), Persons, 51, takes only ancillary interest in the stock market. His search for hidden gems is focused squarely on the bond market, where he spends much of his time scrutinizing BB-rated bonds, the highest rating for junk bonds, for companies he thinks are destined for investment-grade status.

MFS' bond manager Robert Persons looks for high-yield bonds of quality companies that may be upgraded.
Jason Grow for Barron's

Credit-rating agencies determine which bonds are BB and which are BBB, and while the differences are often nominal, the implications are enormous. "That delineation determines what pension funds and other big investors can and cannot buy," says Persons, who along with co-manager Richard Hawkins took over the fund in 2005. When a bond gets upgraded to investment grade, demand increases instantly, he says, "like flipping a switch."

Though roughly 80% of the fund's more than 300 holdings are investment-grade corporate bonds, Persons credits those up-and-coming BB-rated bonds—roughly 14% of the fund—with its stellar results. Over the past five years, the fund has averaged 8.06% annual returns, better than 95% of its intermediate-term bond fund peers. Meanwhile, it offers a generous 3.8% dividend yield. "We try to keep it simple—no derivatives, no currencies—just bonds from companies most people have heard of," says Persons, who also eschews Treasuries and mortgage-backed securities. The focus on corporate bonds began in 2009, though Persons says he has no intention of going back into Treasuries or mortgage-backed bonds in the foreseeable future.

Persons first became intrigued with investing following a mock-portfolio project as an undergraduate at Bucknell University. When the sports junkie started checking stock prices before baseball scores, he knew he'd found his calling. He headed to business school at Northwestern University and set his sights on becoming an equity analyst—until an opportunity covering corporate bonds opened his eyes to the many facets of the debt markets. "For years, I sat in the classroom listening to professors talk about how the markets are efficient," he says. "I think I've found my inefficient market."

To find mispriced bonds, Persons, Hawkins, and their team of a dozen credit analysts—who work closely with their equity counterparts—screen for companies with strong and improving fundamentals. "One of the most important factors is whether the company has a business model that is defensible through an entire cycle," says Persons. He favors companies with strong cash flow, and well-spread debt maturities; when too much debt is due at once there is increased refinancing risk, he says.

Persons also pays close attention to stock prices, particularly in the case of BB-rated bonds. "A stock price more efficiently represents the value of a company on the cusp of an upgrade," he says, explaining that there are more analysts following the stocks than bonds, and changes in outlooks are reflected immediately.

In the meantime, he says, BB-rated bonds tend to fly under the radar. Many investors can't buy them, he says, and high-yield investors aren't going out of their way to scoop up 5% yields.

When a BB bond does get promoted to investment grade, its price tends to shoot up one or two percentage points immediately. "When Ford was upgraded to investment grade, it went up four points in one day," says Persons of one of his holdings. "That was exceptional."

Last year, 15 of the fund's BB holdings got upgrades, and so far in 2013, six of the fund's holdings have been bumped up to investment grade. Among the recent upgrades was Gap, which Standard & Poor's deemed investment grade in May. The bond is worth 12% more than what Persons paid last spring. "For an investment-grade bond," he says, "that's pretty heady stuff."

MFS Bond Fund

Total Returns*

1-Yr

3-Yr

5-Yr

MFBFX

1.78%

6.42%

8.06%

Barclays U.S. Credit Bond Index

0.18

5.52

6.81

% of

Top-10 Holdings

CUSIP

Portfolio**

Life Technologies

53217VAC

1.08%

Gap

364760AK

1.06

Dollar General

256677AA

0.80

Bank of America

06051GET

0.79

Mohawk Industries

608190AH

0.76

Moody's

615369AB

0.76

Lorillard Tobacco

544152AA

0.73

Constellation Brands

21036PAD

0.70

Plains Exp & Prod

726505AP

0.68

Discover Bank

25466AAB

0.68

Total:

8.04%

*All returns are as of 6/26/13; three- and five-year returns are annualized. ** As of 5/31/13. Sources: Morningstar; MFS

Persons tends to hold onto these high-yielding bonds, even after the price pops on an upgrade announcement.

Chemicals and plastics giant
LyondellBasell Industries LYB 0.03418024381907257%LyondellBasell Industries N.V. Cl AU.S.: NYSEUSD87.8
0.030.03418024381907257%
/Date(1427835749780-0500)/
Volume (Delayed 15m)
:
2725466AFTER HOURSUSD87.7121
-0.0878999999999906-0.1001138952164009%
Volume (Delayed 15m)
:
40153
P/E Ratio
10.941218986379553Market Cap
41866025903.0252
Dividend Yield
3.1890660592255125% Rev. per Employee
3481530More quote details and news »LYBinYour ValueYour ChangeShort position
(LYB), another large holding, made the move to investment grade in March. When Persons bought the bond last June, it was selling at par rated BB—a hangover from an unsuccessful leveraged buyout prior to the credit crisis and subsequent bankruptcy. As Persons saw it, LyondellBasell has two things going for it: It came out of bankruptcy with a better balance sheet just as a drop in prices of natural-gas, which it uses to make many of its products, has driven up margins. The company, he says, is generating enough cash flow to pay off all of its debt in less than two years. "This is a company that could be a single-A rating," he says. The bond, meanwhile, is up 9% since he bought it.

DOUBLE-DIGIT RETURNS are terrific, but Persons understands that bond investors' top priority is capital preservation. That, he says, is the real benefit of handpicking bonds just above and below investment grade.

"On one hand, AAA bonds are the safest when it comes to the risk of default, but historically those securities are most vulnerable to rising interest rates," he says. "The higher the quality, the closer the correlation to Treasuries." With yields already so low, they have the most to lose when rates go up.

On the other end of the spectrum, bonds with lower credit ratings tend to have a stronger correlation with stocks. When the S&P 500 increased 8.8% between November 2010 and February 2011, for example, U.S. Treasuries fell 7.5%, while AA-rated industrials were down more than 4%. During that time, BB-rated industrials increased 1%, and B-rated industrials were up 2.8%. "It's difficult to grasp the concept that adding high yield can actually reduce risk," he says. "The key is defining risk."

Through careful research, says Persons, it's possible to find bonds that offer some of both—little risk of default and a bigger cushion against rising rates.